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Buyer Furnished Equipment: an aerospace challenge Ref 311-235-1 Case Study Dr. Leandro De Sa et al. prepared this case. This case was developed from published sources and field based interviews solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. © 2011, IAE Toulouse

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311-235-1

Buyer Furnished Equipment: an aerospace challenge by Dr. Leandro De Sa, Dr. Ludovic Cailluet, Thomas Yefsah, Rossana Aguia, Gwennan Saout1

His friend SVP Equipment Procurement at Airbus, François Mery, didn’t take long to reflect on the open question that was addressed to him “so if you’d pick a clearly dysfunctional area in aircraft procurement what would that be?”. He took a brief pause, more to weight in the answer than as a deeply thoughtful attitude that the question didn’t call for and threw “BFE!”.

1 Context of the Aerospace Civil Market supply chains The industry for civil aircraft above 100 seats is dominated by two main OEMs (Original Equipment Manufacturers): Boeing and Airbus. Regional aircraft OEMs include ATR, Bombardier and Embraer as the main players. A set of new players is now emerging, with the recent development by Comac of China of the C919, Sukhoi’s Superjet or Irkut’s MC21. Supply Chains for Airbus and Boeing equipment are typically mature and fairly common to both, with some specialties. There have traditionally been two types of equipment fitted on aircraft, Supplier Furnished Equipment (SFE) and Buyer Furnished Equipment (BFE). SFEs typically involve flight-required equipment, critical for the aircraft type certificate: avionics, landing gear, wheels and brakes, air conditioning and bleed, electricity, flight controls, hydraulics, fuel systems,… BFEs on the other hand involve heavy airline customization issues pertaining to the cabin and to the airline-to-passenger relationship: galleys, lavatories, panels, seats, in-flight entertainment systems (IFE),… SFEs have been progressively structured into system suppliers, lesser and bigger risksharing suppliers able to cope with a strongly integrated and synchronized industrial supply-chain management. BFEs on the other hand have been mostly kept within splinter and direct agreements with the airlines.

2 The Airline Industry and Competitive Market A competitive and sustainable airline industry abides to a similar strategic positioning than other industries: the only two really sustainable routes are low cost and strong differentiation. Low Cost Carriers (LCC) have been championed by Southwest Airlines since several decades. Variants of this model now exist in Europe, with Easyjet and Ryanair, in Asia, and 1

Dr. Leandro De Sa et al. prepared this case. This case was developed from published sources and field based interviews solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. L. De Sa et al. © Buyer Furnished Equipment: an aerospace challenge 2

311-235-1 in the US, namely with Jetblue. LCCs require a fairly standard cabin but extremely reliable. They can go to the length of simplifying products, e.g. seats in Easyjet aircraft cannot recline. IFEs are either inexistent or very simplified and robust. Strong differentiators have a radically different approach, being heavy adopters of dedicated and sophisticated IFEs, Business and First Class seats,…

3 The BFE Market 3.1 Supply Chain Issues With SFEs, the chain of command is perceived as classical and linear while the BFEs presents a more complex structure. First, there is a challenge to coordinate the different suppliers and integrate their systems before delivering them to the manufacturers (e.g. an IFE system within a seat or an electrical insert into a galley). In that respect, Aircraft Manufacturers seek to have the simplest relationship in terms of contract in order to prevent delay issues. Seamless application of Lean, Six Sigma, Total Quality Management and other supply chain control structured processes is very recessive in the case of BFEs since there is a clear lack of control and full accountability.

3.2 The Airlines’ position These actors would appreciate the entry of new players in both the BFE market (e.g. to break Panasonic’s dominant position in IFEs) and the Aircraft Manufacturing market, in order to revitalize both markets through a better competitive edge. Airlines are constantly seeking to differentiate from each other according to their passenger’s segmentation. The large range of prices and margins recorded by every segment of passengers, from 1st class to economy class, reinforces the need for cabin’s customization. On the 1st Class segment differentiation is key. Hence, demand is less price elastic. Peripheral services such as lounges taken aside, the 1st Class competitive advantage is mainly relying on the acquisition of new cabin items and the improvement of the comfort of the cabin. This leads to a race for innovation among the BFE suppliers. The spread of flight ticket pricing from non-refundable economy class to full status 1st Class is now about a 1-to-40 ratio. The choice of putting a new item into the cabin may be motivated by different reasons according to the Airline Company’s profile. First, from the low-cost carriers’ (LCC) point of view, every new item is added only after a deep analysis of its profitability. On the other hand, the cabin’s equipment is a key element for the legacy carriers’ strategy of differentiation. It appears that the last ones used to install new item to respond to their competitors’ new acquisition. Consequently, the low costs carriers do not invest in BFE market as frequently as the legacy carriers.

3.3 Seats There are over 400,000 seats produced on the BFE market every year (the concept of seat includes the combination of the seat plus other BFE products integrated into it, like the IFE systems). This volume is based upon the life cycle of these products: a 1st class seat has a life cycle of five years while an economic class seat may be used between ten to twelve years. The 1st class seat prices vary between $35,000 and $150,000 whereas the prices for economic class seat vary between $2000 and $6000. A 1st Class seat has dramatically L. De Sa et al. ©

Buyer Furnished Equipment: an aerospace challenge 3

311-235-1 increased its technological complexity to the point where it can have now up to 10 different motors and actuators inside and a complex IFE integration. Throughout the life cycle of a plane, the cabin is usually refurbished a few times in order to harmonize the whole fleet of the Airline Company to new sets of competitive standards. For every change in the cabin configuration, an entire certification process must be engaged. Seat producers and their market shares are described in Exhibit 7.1.

3.3.1 BE Aerospace Mike Baughan, President and COO of BE Aerospace, the largest aircraft seat manufacturer based in Winston-Salem, North Carolina, emphasized “For Coach seating, as proven with RBS (Royal Bank of Scotland’s Leasing Company) and ILFC (International Lease Finance Corp.), we can provide a platform product, with the various options, pre-certified, and predetermine what the IFE interfaces will be. This allows a fairly straightforward certification, short delivery leadtimes, while enabling a pre-determined set of fabric, color,… and other choices. This has allowed us to always be on time with Airbus for a long period of time now. Though it is still under a BFE classification, it does utilize an SFE-like disciplined approach”. Baughan had a very different tone to Business and 1st Class Seats: “Here things are considerably more complex. Airlines will want a number of their A330 solutions to also be adaptable on their B777, future B787, A350,… So the problem becomes much more complex and multi-aircraft. What you need to have is a disciplined approach to customization and interface management with IFE. This is the highest risk item in seating today. IFE keeps changing their interfaces in the wake of new generations of devices, quite often not of a mature technology and so subject to bugs. Going SFE on Business and 1st will meet extreme failure. United and BA have the same aircraft, and yet chose very different configuration in 1st and Business. Their position here is irreconcilable as none would ever want to accept the other one’s configuration as a ‘better’ one. It is too tightly knit to the profit of the airline. There’s no way to pre-certify every possible configuration here.” BE Aerospace is a manufacturer of cabin interior products for commercial aircraft and business jets and a distributor of aerospace fasteners and consumables. Revenues in 2009 were $1.94 Billion, and the market cap at the end of the first quarter of 2010 was $3.1 Billion (see Exhibit 7.2 for selected financials of the main seat manufacturers) or a PE Multiple at around 12.5. The Cabin Interior Revenues in 2009 were $911,3 Million, down from $1.14 Billion in 2008.

3.3.2 Zodiac Aerospace Zodiac Aerospace specializes in the design, production, and marketing of aeronautical equipment. Net sales of €2.21 Billion in 2009 break down by family of products as follows: -

Cabin Interiors segment (51.5%): passenger seats, on-board sanitary systems, pilot seats, etc.;

L. De Sa et al. ©

Buyer Furnished Equipment: an aerospace challenge 4

311-235-1 -

Aircraft systems Segment (25.6%): oxygen systems, fuel systems, electrical power management systems, etc.; AeroSafety & Technology Segment (22.9%): escape slides, parachute systems, electrical wiring protection systems, automotive airbags, remote transmission systems, etc.

Net sales are distributed geographically as follows: Europe (40.8%), America (43%), and other (16.2%).

3.3.3 Recaro RECARO GmbH & Co. KG, commonly known as Recaro, is a German company based in Kirchheim unter Teck in the vicinity of Stuttgart, known for their automobile bucket seats. The company can produce OEM racing-style seats for mainstream manufacturers, but diversified its product and customer portfolio strongly in the nineties to include wheelchairs, as well as aircraft seats for airlines, automotive children seats, and train seats.

3.3.4 Other manufacturers These include Contour Aircraft Premium Seating, Thompson Solutions, European Aviation and Acro Aircraft Seating in the United Kingdom, EADS Sogerma of France, Avio Interiors and Geven SpA of Italy, Koito Industries Ltd of Japan, Greiner PURtec of Austria, DeCrane Aerospace and Aero Seating Technologies of the United States. A major fraudulent problem occurred in February 2010 as Koito confirmed it had breached safety rules over several years. A number of tests including crashworthiness and flammability had to be conducted by Koito. If the results were to be negative, as many as 150,000 seats on 1,000 aircraft could be affected, according to data released by the Japanese government. A number of aircraft including Continental Airlines’ to be delivered by Boeing would get important delays. In the extreme case where the Koito seats could not be certified, an Airworthiness Directive could be issued that would ground all of the concerned aircraft. Views from the industry were however optimistic about this situation. However, this event proved that seat manufacturers could become extremely critical in the delivery and certification of the aircraft.

3.3.5 Issues for seats

3.3.5.1 Weight Mike Baughan from BE Aerospace commented that “half of our backlog is due to weight and the process to reduce it: over $250M sales and over 600 shipsets of commitments for a variety of customers. A recent trend for airlines is to acknowledge the weight problem namely in the light of their own specifications. So there has been in the last 1 to 2 years a coordinated approach in the industry to reduce weight. The market for Coach seats has become very weight-sensitive. A lot of those weight issues involve interfaces: for instance, why are there seat tracks where they are? No-one can answer this question other than ‘they are where they are because they were there before’. Sometimes this goes all the way back to the B757. So working on an efficient seat interface management could yield results. This is starting to happen.” L. De Sa et al. ©

Buyer Furnished Equipment: an aerospace challenge 5

311-235-1 The total weight of a cabin can be 0.5% to 0.8% of MTOW (Max Take-Off Weight) or up to 1.5 Tons. This extra marginal weight reduces the airline’s profitability, deprives it from extra filling capacity on the aircraft and/or reduces aircraft performance.

3.3.5.2 Reliability “As a leasing company, reliability of the seats and BFE in general is our number one criteria when assessing the cabin interiors of our aircraft. We need to have a sustainable model, resilient to turnarounds, capable of addressing our multiple customer base. Price will only be a marginal function here, as the cost implications of an unreliable product are far more pervasive than price itself’, would comment Rodolphe Demarcq, vice president of Technical Asset Management at RBS Aviation Capital. As the current market conditions went, reliability tended to come top in the selection list even in the cases where the aircraft were owned by the airlines. “If a First Class customer has its video or seat malfunctioning, we will reimburse the fare. That’s a costly stake for us, so we’d better have a truly reliable product”, would offer Patrice Provost from Air France.

3.3.5.3 Integration of IFE Management of the integration process of IFEs into seats became over time a complex process. This was due to the disconnected and loose contractual linkage between the airline, the IFE provider, the seat provider and finally the OEM. The airline would contract with the IFE and the seat supplier separately, then require the IFE supplier to manage interfaces with the seat manufacturer so that the latter could integrate it into a complete shipset to be delivered to the OEM assembly line. Containing the supply chain became challenging as the main contractual link remained with the non-industrial stakeholder, the airline, ultimately the recipient of the complete product. The cabling process also increased dramatically in complexity, furthering the integration maze.

3.3.5.4 Value for money An airline senior executive would comment “I see a First Class seat priced at nearly $100,000 apiece, then I look again in detail and can’t help thinking ‘I don’t have value for that kind of money’. Why am I captive in this situation?” Although Business and First Class customers have traditionally been the cash cows of airlines, there’s a) the ramping debate about Premium Economy classes that could cannibalize Business Class, b) the exacerbation of Business and First customers’ expectations, to always more, and c) the fine tuning of a value proposition to cost-conscious customers, even in the high end, to a more balanced economics situation. In other words, reflect on the product in the frame of customer and airline economics as opposed to a pure parrot ladder competition, a tit-for-tat that could scar the industry hopelessly.

3.4 In-Flight Entertainment 3.4.1 In-Flight Entertainment Competitive Situation Panasonic Avionics Corporation has held the leading position on the IFE market since 30 years (see Exhibits 7.3 and 7.4). The leadership of Panasonic is sustained due to the L. De Sa et al. ©

Buyer Furnished Equipment: an aerospace challenge 6

311-235-1 important switching costs. Moreover, they demonstrated their ability to set their technological standards, which, to some extent, creates dependencies at the aircraft manufacturers. Finally, they established their reputation on the market and are now considered as a reliable partner by IFE customers. Bob Lange at Airbus Marketing would add that because of this seemingly “monopolistic” situation, the IFE market remained inefficient in term of price and innovation. This market structure is the result of high barriers to entry. First, the newcomers need to build a brand name in the area. Second, huge investments are required in order to develop the IFE systems. Third, the cost of switching IFE supplier deters airlines from looking at other options and then impedes the entry of potential players. These switching costs pertain to a) the costs of content management, b) the cost of the imbedded infrastructure (servers, cables, seat interfaces,…), c) the cost of refurbishment and configuration management, namely of mixed fleets and aircraft downtime during Working Parties. In the past, many of new IFE suppliers failed to enter the market. For Bob Lange, Panasonic Avionics, “the giant in the room”, “the two hundred pounds gorilla”, may be considered by analogy as “the Intel Inside of Airplanes”. Thanks to this leading position on the market, Panasonic Avionics can prevent new entrants from competing on a long-term perspective. Indeed, Panasonic Avionics has the capacity to copy any changing technology and then push the new entrant out of business. Lange added that even in the case of a “breakthrough” innovation, the company might either merge or acquire the new entity thanks to its financial capabilities.

3.4.2 Panasonic Avionics Corporation “We are observing a dual segmentation in the airline sector between low cost segment and the high cost segment”, says Mark Jennings, the executive director of Panasonic Avionics, “with the BFE system aircraft manufacturers are encountering important waste of engineer and management efforts during the aircraft building process. The BFE market as it is established today is not viable as it pushes the BFE suppliers’ industrial process towards too many risks”. Panasonic Avionics Corporation (PAC, previously incorporated as Matsushita Avionics Systems) is a subsidiary of Panasonic Corporation and is headquartered in Lake Forest, California. Remarkable facts & figures for Panasonic: – – – –

–

Panasonic Corporation’s Net Sales = $79 Billion Panasonic has over 305,000 employees worldwide 30 years exclusively in the IFE industry Global Staff (3,282 employees, 78 locations) as of March 2009 o Americas (1,874) o Japan (773) o Europe (267) o Asia (179) o Middle East (140) o Oceania (49) Equipment Manufacturing

L. De Sa et al. ©

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311-235-1 o Osaka, Japan o Lake Forest California The main issues for Panasonic Avionics are:  The licensing fees for movies  The maintainability  Speed of movies’ transfer. SFEs have a potential life cycle of 15 years. There is a lesser rush towards innovation. Conversely, BFEs and IFEs, with a 3 years life cycle, have a high need for innovation to sustain growth. Innovation is highly important for airlines to gain differentiation. How to protect the industrial processes while ensuring constant innovation and renewal for the airlines? Of Panasonic’s turnover of approximately $79 billion, the IFE sector represents only about $1 billion. The Panasonic’s specialization on the IFE segment started from a project that aimed and putting a radio in an airplane, followed by an exploration of new ideas for airplanes. In the eighties, it started to produce IFE of its own. The story of Panasonic Avionics Corporation in the product definition is reported on its website as follows: 1992 • Introduced System 2000 1998 • Introduced audio video on demand (AVOD) 1.0 2002 • Northwest IDS Design Silver Award–eFX peripherals 2005 • Panasonic announces 5th Generation AVOD System • First IFE vendor to adopt RoHS, environmental design 2006 • eX2...